Coming Employer Crackdown On 401(k) Loans?

In an effort to educate employers about how employees’ 401(k) balances are being decimated by allowing serial loans,
Fidelity Investments sent an infographic to their 20,600 employer clients, and they responded in droves by asking what they can do to limit their employees ability to raid their 401(k) accounts.

How can one similarly paid employee with the same asset allocation end up with a 401(k) worth just over a third of his colleague’s? Easy, when you can just take the money out. The graphic shows three imaginary 55-year-old employees earning $100,000 a year with $100,000 saved so far. Their hypothetical pre-tax savings after 10 years is:

$364,000 for Jen who contributed 10% of her salary and took no loans or hardship withdrawals

$313,000 for Lisa who contributed 13% of her salary, and took a series of 10 loans totaling $117,000 keeping current with loan payments

$131,000 for Hugh who contributed 10% of his salary, and took a series of loans and hardship withdrawals, totaling $186,000.

Obviously Jen is the winner.

Lisa comes in second, having continued to contribute to the plan while the loans were outstanding. And unlike many who take loans, Lisa did not lower her deferral rate. Fidelity found that borrowers lowered their contributions by an average of 2 percentage points, and and it’s typically five years until they get back up to their old deferral rate of say 6% from 4%. Yet even though Lisa saved 13% compared to Jane’s 10%, and did not lower her deferral rate, she has not saved as much as Jane – her repeat loan usage is to blame.

Hugh is in the worst shape. He took multiple loans totaling $126,000 and a hardship withdrawal of $60,000. Hardship withdrawals come at a greater cost than loans because once you’ve taken a hardship withdrawal, you’re not allowed to make contributions to your 401(k) for six months, and you can’t repay the money back into your account (there’s also a 10% penalty).

401(k) borrowing is all too common. Out of the 12.3 million employees in Fidelity plans, one out of every five 401(k) plan participants has a loan outstanding, and one in nine took a new loan in the past year, with an average loan amount of $9,000, while 2.3% of participants took hardship withdrawals.

Fidelity found that half of borrowers take more than one loan, and that the likelihood of taking a hardship withdrawal rises dramatically among multiple borrowers (climbing steadily from 6% for those who have taken one loan to 27% for those who have taken 7 loans). That got employers’ attention. “Employers want to get a better picture of how much of an issue this is in their organization,” says Jeanne Thompson, vice president at Fidelity. “Plans that offer more than two loans are asking to see if serial borrowing is an issue in the plan,” she says.

What actions might employers take? Employers can prohibit 401(k) loans altogether, or they can reduce the number of loans allowed outstanding at one time. Today about third of plan allow only one outstanding loan at a time, 42% allow two outstanding loans at a time, and about a quarter allow more than two loans out at a time.

Employers might also extend the waiting period between taking loans. Typically after a loan is paid back, you have to wait six months before you can take another loan.

As to hardship withdrawals, there are two different standards for deciding whether an employee request counts. The first, more restrictive standard, is the Internal Revenue Service safe harbor standard. That includes foreclosure of your home and medical expenses, the two most common reasons for employees to take hardship withdrawals. The other standard, which Thompson says employers might want to cast aside, is a facts and circumstances standard that is more encompassing.

Automatically reinstating contributions after they were suspended for a hardship withdrawal is another way employers can help keep employees on track.

What should employees do? Build up an emergency savings pot outside of your 401(k) to save for things that people tend to take 401(k) loans for –like paying for college, says Thompson. If you do take a loan, if possible, continue to contribute regular salary deferrals into your 401(k)—and don’t reduce the amount.